Saturday, June 28, 2008

There is a time bomb about to explode and it has to do with pension funds that invested in risky and no-so-risky colateralized debt obligations (CDOs). Last July, Bloomberg markets wrote an excellent piece entitled, The Poison in Your Pension (click hyperlink to view). The article describes how banks were selling the riskiest CDO tranches, known as toxic waste, to public pension funds and state trust funds (click on image above to see who are the buyers of CDOs).

CDOs are packages of securities backed by bonds, mortgages and other loans. It turns out that some large public pension funds, including the California Public Employees' Retirement System (CalPERS), the largest U.S. public pension fund, invested in the equity tranches of CDOs to boost their returns. And CalPERS was not the only public pension fund to invest in these risky assets.

Once the subprime crisis hit, the values of these securities plummeted. I quote from the article:

"Because CDO contents are secretive, fund managers can't easily track the value of the components that go into these bundles. ``You need to monitor the collateral in your investment and make sure you're comfortable there will be no defaults,'' says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis. Most investors can't do that because it's extremely difficult to track the contents of any CDO or its current value, he says. About half of all CDOs sold in the U.S. in 2006 were loaded with subprime mortgage debt, according to Moody's and Morgan Stanley. Since CDO managers can change the contents of a CDO after it's sold, investors may not know how much subprime risk they face, Das says."

The highest-rated slices of CDOs are sometimes called super-senior tranches because investors get their payments before owners of the riskier equity tranches. But as it turns out, the value of even the highest-rated CDO tranches are being marked down. In April, a ratings downgrade by Moody's Investors Service slammed a CDO issued by an affiliate of Fidelity Investments.

Why is this important for pension plans? Because many pension plans are exposed to senior CDO tranches with AAA ratings and if the downgrades continue - which seems highly likely - the ripple effects will be felt all over global financial markets. By law, most public pension funds in the U.S. and elsewhere are not allowed to carry anything but AAA tranches on their books.

Last June, Bloomberg carried this article stating that Moody's and S&P are masking $200 billion of subprime bond risk. I quote the following:

"Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets."

So far, we have heard about banks and insurance companies taking massive writedowns but not much has been mentioned about pension fund losses on CDOs. We did hear about losses on asset backed commercial paper here in Canada (ABCP) but we have yet to hear any news on CDO losses.

All that may be about to change as CDOs look primed for more distress. Moody's Investors Service recently cut MBIA Inc., a bond insurer, to A2 from Aaa late Thursday - a two-notch downgrade bigger than some investors expected. The ratings agency also lowered Ambac Financial to Aa3 from Aaa.

"Bond insurers, also known on monolines, are important because they guarantee more than $1 trillion worth of securities. When they're downgraded, all the securities they back get downgraded as well - potentially meaning a knock-on effect for investment banks and other financial institutions that bought guarantees from bond insurers to hedge mortgage-backed securities and more complex vehicles known as collateralized debt obligations, or CDOs."

I expect the next wave of downgrades to hit all CDO tranches, including the senior and super senior tranches. A recent analysis by Naked Capitalism clearly explains the problem with CDOs:

"A concern recently voiced in the marketplace, beyond the conflict of interest, is that the rating agencies lack the skills to rate these instruments, since they are often composed of pools of underlying instruments that themselves are difficult to model. For example, mortgage backed securities (which were already tranched) can go into CDOs. To put it bluntly, anyone at a rating agency who is skilled enough to model a CDO will make more money working for an investment bank or money manager, so they cannot hang on to the staff with the crucial know-how.

Now this wouldn't matter so much if these instruments were marked to market. The shortcomings of the rating agencies would be captured in the marketplace (it's common for corporate bonds to trade down before the rating agency works up the nerve to downgrade them). However, pension funds and some other institutional investors are not marking these CDOS to market."

Just like the banks and insurance companies, once pension funds start marking the CDOs to market, they will have to report the losses they suffered from holding these instruments on their books. Once this time bomb explodes it will slam credit markets hard, further exacerbating the ongoing credit crisis.

Why are pension funds investing in passive commodity futures indexes, especially here in Canada where the S&P/TSX is dominated by energy and commodity shares? The rationale for investing into commodities and other hard assets like real estate, infrastructure and timberland is that they are "inflation sensitive" assets and since your pensions are indexed to inflation, pension fund managers decided to diversify their asset allocation and invest in these assets to hedge against unanticipated inflation.

But the diversification rationale is just as weak as the inflation concern. It turns out that in today's environment, commodities are highly correlated to other hard assets like real estate, timberland and infrastructure and just as vulnerable to a global deflationary spiral.

I quote from the article above:

"In the last five years, investment in index funds tied to commodities has grown from $13 billion to $260 billion, and the price of the 25 commodities that compose those indices have jumped 183 percent, according to congressional testimony from Michael Masters, managing member of the Virgin Islands-based hedge fund Masters Capital Management.

Mr. Masters dubs the pension and other investors as "index speculators." He estimates that in the first 52 trading days of this year, they flooded the market with $55 billion -- in a self-fulfilling prophecy of sorts since the more money they put in, the more prices rise."

Importantly, the bulk of that $260 billion is going straight into the Goldman Sachs Commodity Index (GSCI) which is composed of roughly 80% energy futures (mostly oil futures). Goldman Sachs did a great job marketing this index to their institutional clients but nobody stopped to think at what critical juncture does the marginal inflow into these commodity futures start influencing the underlying commodity prices. I guess we got our answer.

I am not just blaming pension funds for the speculative fervor that has gripped oil and commodity markets but they have to share some blame. William Engdahl states that perhaps 60% of today's oil price is pure speculation. The hitch is that regulation to curb speculation might exacerbate the problem as funds move into unregulated markets to place their bets. I quote Engdahl:

"Because the over-the-counter (OTC) and London ICE Futures energy markets are unregulated, there are no precise or reliable figures as to the total dollar value of recent spending on investments in energy commodities, but the estimates are consistently in the range of tens of billions of dollars."

So why are pension funds investing billions into commodity futures? A conspiracy theorist might argue that pension funds, the Fed and the U.S. Treasury desperately want to avoid debt deflation, lower pension liabilities and inflate their way out of their national debt by cheapening the greenback. Unanticipated inflation will bring about higher interest rates which lowers the present value of future pension liabilities. I am not into conspiracy theories but I must admit that this has crossed my mind.

But pension funds should be careful for what they wish for. An article in today's FT discusses how the spike in commodity markets is beginning to hurt leveraged buyout funds (LBOs). I recommend you read the comment posted on Naked Capitalism's site for more details. I mention this because if the BCE deal doesn't go through, Ontario Teachers' and its partners could be on the hook for as much as $1 billion. (I still do not understand how Teachers and their partners will make money from this deal. Debt financing of this scale is extremely risky given today's credit markets and good luck unlocking value from Bell Canada with its antiquated technology).

Thursday, June 26, 2008

Michael Metz, Chief Investment Strategist at Oppenheimer once remarked that "it's worse being a bear when you're right". Indeed, if you make money during a down market, don't tell your neighbors.

Big institutions have all sorts of ways to make money during bear markets including investing in hedge funds as well as developing internal absolute return strategies. Unfortunately, while hedge funds sound sexy, the reality is that most hedge funds are charging fees for disguised beta. Just like private equity funds, if you are not invested in the top hedge funds - and there aren't that many of them increasing their capacity to accept new capital - you are going to get creamed in these treacherous markets.

But there is another way for large and small investors to make money in down markets. Financial engineers have developed new products that anyone can buy and sell to make money when stocks dive. They are called Short and UltraShort Proshares ETFs and you can read all about them here. I have included an image of the UltraShort Proshares I currently track above (click image to enlarge).

You will notice volume was heavy on the UltraShort Financials (SKF) and UltraShort QQQ (QID) today. These ETFs are very volatile and I would not recommend you buy and hold them for long, but when markets puke they are engineered to rise by twice as much as the percentage loss of the underlying stock index. The one I think has more room to run-up is the UltraShort Real Estate Proshares (SRS). Many US REITs are priced for perfection and they face serious headwinds, including:

This brings me to why I believe we are going to experience the Mother of all bear markets. Today was a good day to close my computer early and head off to lunch with a senior pension fund manager who I used to work with. I have tremendous respect for this individual because he is a thinker who reads a lot and is not afraid to question conventional wisdom. He has zero tolerance for petty politics or Monday morning quarterbacks.

Our conversation was extremely interesting. He is bearish these days so we had lots to chat about. He remarked that the BKX index which tracks financials hit an eleven year low. We both agreed that bottoms can only be called after the fact with the benefit of hindsight (always remember Keynes' famous quote that "markets can stay irrational longer than you can stay solvent"). This credit crisis is far from over so despite the selloff, financials might be in the early stages of a long structural bear market.

We then discussed oil prices and the instability of the global financial system. He remarked that in the past, the Fed had a lot more power than it now does to influence financial markets. Global linkages of capital markets spurred by huge pension, mutual and hedge funds have significantly changed the structure of the global financial system. "The world is a much more dangerous place and I fear that the next recession will be very painful."

I completely agree with his assessment. Very few pension funds have contingency plans for global systemic risk. Asset classes are more correlated than ever before and pension fund managers need to start thinking harder about downside risk to the total portfolio, not just individual asset classes. Diversification will not help you in this Ursa Major because the tech bubble subsided only to be replaced by a bigger real estate, private equity, hedge fund and commodity bubble. (I expect a lot more hedge fund blow-ups in the next 12 months, especially in strategies that trade illiquid credit securities.)

"The key question for stock markets is whether the cycle is ending in an inflationary or a deflationary nemesis.Though much has been written and said about the possibility of a return to the stagflation of the 1970s, the bigger long-term threat to share prices would be the deflationary outcome. Experience from the 1930s and Japan from 1990 onwards shows that deflationary influences are profoundly more destructive of equity values than inflationary ones."

He goes on to write:

"Undoubtedly the developed world is in for a very difficult couple of years. Living standards will get squeezed, unemployment will rise and equity markets must logically suffer along with all other asset classes.

At the bottom of the last bear market five years ago, Edward Bonham Carter, chief executive of Jupiter Asset Management, said that it would take until 2010 for the stock market to return to its turn of the century peak. At the time, this seemed unduly pessimistic. If anything, it now looks on the optimistic side. But in the round it seems about right.

A similar period of sideways trading took place from the mid-1960s. In that case it was 17 years before the Dow broke free of the rut it was in. A prolonged period of adjustment, rather than an outright crash, still seems to me the most likely outcome."

I hope Mr. Warner is right but I fear that this will be the Mother of all Ursas and pension funds will suffer severe funding shortfalls as equities and interest rates plummet in a multi-year debt deflation spiral. If that turns out to be the case, pension funds will shun sexy alternative assets altogether and go back to investing in good old boring government bonds.

Tuesday, June 24, 2008

This week, I will dig deeper into the issue of alternative investments, focusing once again on the benchmarks that Board of Directors use to compensate their investment managers at public pension funds.

The bear market that gripped public markets following the tech meltdown was a perfect storm for pension funds. Returns on public stock indexes fell and liabilities grew as interest rates fell to historically low levels.

It's too bad that most pension fund managers and supervisors did not bother reading Swensen's book more carefully. If they did, they would quickly discover that while alternative investments offer tremendous portfolio diversification (at least in theory) and added yield that pensions so desperately seek, they also offer their own set of unique risks that need to be reflected in the benchmarks that pension funds use to assess the performance of these investments.

I will continue to make the case that benchmarks of alternative investments at most of the large Canadian (and global) public pension funds do not accurately reflect the risks of the underlying portfolio. The table above looks at the 2007 returns of Real Estate returns relative to their benchmark returns from the five following pension funds:

All the information was obtained from the publicly available annual reports. You can click on the table above to enlarge the image. It is important to remember that the Caisse, OTPP and OMERS have fiscal years that end December 31st while CPPIB's and PSPIB's fiscal years end March 31st.

Nevertheless, the table clearly shows that Real Estate at OTPP, OMERS, CPPIB and PSPIB significantly outperformed the asset class benchmarks at these pension funds. Conversely, Real Estate underperformed its benchmark at the Caisse by 3.5% in 2007. What explains this discrepancy? The simple answer is that the Caisse's Real Estate benchmark does a better job accounting for the underlying risk and beta of its real estate investments. (Those of you who want to dig deeper into institutional real estate as an asset class should consult TIAA-CREF Asset Management's research.)

I can't overemphasize the point that benchmarks matter because compensation is based on benchmarks. The next time your pension fund manager boasts of creating "significant value added", check in what asset class this alpha came from and check the benchmark of that asset class. Chances are that the "significant value added" came from private investments into real estate, private equity or infrastructure. In almost every case, if the asset class "significantly outperformed" its benchmark, it is because that benchmark does not account for the risks or beta of the underlying portfolio.

Now, if you want an example of a large pension fund that has done an excellent job thinking about its benchmarks and properly disclosing them in their annual report, look at the annual report of the California State Teachers' Retirement System (CALSTRS) (see footnotes on page 61 for details on each asset class benchmark). In my opinion, CALTRS is way ahead of its peers in terms of proper governance, proper disclosure and using proper benchmarks that accurately reflect the underlying beta and risks of each asset class. It is hardly surprising that CALSTRS consistently ranks among the first percentile of large public pension fund peers.

I can go on and on about flimsy benchmarks in alternative investments, including bogus benchmarks governing hedge funds or absolute return strategies at pension funds, but I will leave that for another time.

The important point is that when it comes to evaluating "alpha", make sure you ask your pension fund managers and the Board of Directors some tough questions regarding the benchmarks they use to measure the performance of every investment activity and make sure those benchmarks accurately reflect the 'beta' and risks of the underlying portfolio.

I end my post by wishing all Quebecers Bonne Fête Nationale and by paying a tribute to George Carlin, one of the greatest anti-establishment comedians of our time. Carlin died yesterday at the age of 71. Here is his classic skit on "The American Dream". The world needs more George Carlins and less establishment monkeys.

Sunday, June 15, 2008

The asset-backed commercial paper (ABCP) crisis that hit Canada last August highlights the need to look deeper into a subject that receives little attention in the financial press, namely, pension governance.

So what does the ABCP crisis have to do with pension governance? It turns out, a lot. Pension governance is the system of structures and processes implemented to ensure both the compliance with laws and the effective and efficient administration and investment of the pension plan.

In essence, pension governance covers the "who" and the "what" of decision making at pension funds. Who is ultimately responsible for investment decisions and what are the processes used to make sure investment and operational risks are properly managed, ensuring that the pension promise will be met without taking undue risks.

The six key areas of pension governance are oversight, legislative compliance, plan funding, asset management, benefit administration, and communication. In this post, I will focus on a few topics concerning asset management given that this area receives the most attention in the the media. Having worked at two of the largest public pension funds across public and private markets, including alternative investments such as hedge funds and private equity, I am well placed to highlight the main deficiencies that I see in the way pension funds report their performance.

The media typically covers annual reports in a very summary fashion. For example, we all read that the Caisse de dépôt et placement du Québec (Caisse) realized gains of 5.6% in 2007 while the Ontario Teachers' Pension Plan (OTPP) earned 4.5% annual rate of return. OTPP's annual return was 2.2% above its composite benchmark while the Caisse's annual return was 0.6% below its composite benchmark (0.7% above its composite benchmark excluding the write-downs from their ABCP holdings).

Are you confused? What does this all mean? How do you properly compare the performance of big pension funds like the Caisse and OTPP? The short answer to this question is that you need to know what are the risk-adjusted returns of the pension investments and what expenses were incurred to attain these returns. A higher annual return can be achieved taking higher risks and paying higher fees, so beware of headline numbers. Also, keep in mind that some pension funds have different periods covering their fiscal years. The Caisse and OTPP's fiscal years end in December 31st while PSP Investments and the Canada Pension Plan Investment Board's (CPPIB) fiscal years end March 31st.

In order to properly compare the performance of pension funds, you need to know what are the underlying benchmarks of each and every investment activity underlying the overall returns and the annual standard deviations of these benchmarks. Using this information, you can derive the Information Ratio of each pension fund. The Information Ratio measures the excess return of an investment manager divided by the amount of risk the manager takes relative to a benchmark. It is used in the analysis of performance of pension funds, mutual funds, hedge funds, etc.

The term "alpha" typically refers to the annualized excess investment return over benchmark. The policy benchmark portfolio (the 'asset mix') is usually approved by the Board of Directors and senior management at the pension fund is responsible to beat the composite benchmark index. Typical benchmarks for stocks and bonds here in Canada include the S&P/TSX, the S&P500 and the Scotia Capital Bond Universe. Typical benchmarks for inflation-sensitive assets like commodities, real estate and infrastructure are some spread over inflation. The Board of Directors approve the policy portfolio and they approve the weights and ranges in each asset class. Any deviations from those weights are treated as active management decision, where the pension fund's senior management assumes the risk of being overweight or underweight a certain asset class.

Senior managers of pension funds are concerned with beating the benchmark for their asset class, beating the overall policy benchmark portfolio and achieving the actuarial rate of return over a period of time to make sure that the pension liabilities will be met. But their first interest is to beat their asset class's benchmark so they can receive their bonus at the end of the year. This is important to understand and I will come back to it later.

The problem is that very few pension funds explicitly report their benchmarks for each and every investment activity, their alpha targets and their annual risk risk budgets. For example, PSP Investments publicly states that its Board has set the following investment objectives on both absolute and relative performance:

Absolute Performance: Achieving a return (net of expenses) at least equal to the actuarial rate of return as determined by the Chief Actuary of Canada; and

But what is the approved risk budget to attain 0.5% net of expenses over the policy benchmark? In its Statement of Investment Policies, Standards and Procedures, PSP fails to disclose the benchmarks for its real estate and infrastructure investments citing "competitive reasons". Interestingly, on page 67 of the Annual Report 2007, we see that Real Estate accounted for the bulk of the alpha in FY2007, earning 36.5%,a whopping 29.8% above the benchmark return of 6.7%!!! Similarly, for FY2006, Real Estate returned 21.6% or 13.3% above its benchmark return of 8.3%. (Notice how the public market asset classes delivered close to benchmark returns).

Obviously, there is a clear "risk'" disconnect between the benchmark for real estate and the investments made into the real estate portfolio. If this is the case, then why not disclose the benchmark for real estate? Why is this important? For the simple reason that performance is tied in to compensation. If you look at the top five salaries paid out in 2007 at PSP Investments (page 50), you will see that 3 of them came in the real estate group.

When you are paying out these type of salaries and bonuses at a public pension fund, the public has a right to know what are the benchmarks used to evaluate the performance of each internal and external manager. Moreover, independent specialized consultants should conduct thorough performance and operational audits in each investment activity so stakeholders know that appropriate risks were taken to beat their benchmarks. These reports should go directly to the Board or government supervisors and their content should be publicly disclosed on the pension fund's website.

I am using PSP Investments as an example here but I can just as easily use other well known public pension funds in Canada (including the ones I mentioned above) to make my point. Over the last five years, the bulk of the "alpha" from every large Canadian (and global) pension fund came from private market investments into real estate, private equity, and infrastructure. In many cases, the performance of these asset classes trounced the benchmark by 10%, 20%,30% or more!!!

If compensation is tied to performance and benchmarks, doesn't the public have a right to know whether or not the benchmarks used to evaluate this performance accurately reflect the risks taken by the investment manager(s)?

The dirtiest secret in the pension fund world is that benchmarks used to reference the performance of private investments and hedge fund activities in public pension funds are grossly underestimating the risks taken by the managers to achieve their returns. Moreover, most of the "alpha" from these investment activities is just "beta" of the underlying asset class. Why are pension executives being compensated for what is essentially beta?!?!?

There is a disconnect between public market benchmarks and private market benchmarks. Most pension funds use well known public market benchmarks like the S&P 500 to evaluate the performance of their internal and external managers. Public market benchmarks are well known and for the most part, they accurately reflect the risks that investment managers are taking.

But there are no standard private market benchmarks; these investments are illiquid and valued on a quarterly basis with lags. This leads to some serious issues. In particular, if the underlying benchmark does not reflect the risk of private market investments, a pension fund can wipe out its entire risk budget if real estate or private equity gets hit hard in any given year, which is not hard to fathom in the current environment.

Given my training in economic theory, I believe in opportunity cost. Private market benchmarks should be based on public market benchmarks with a spread for illiquidity and leverage. Most pension funds use a spread over inflation, which sounds reasonable until you look at the risks they are taking to achieve their returns in private markets.

Benchmark issues also happen in public markets, but to a much lesser extent (how many U.S. large cap investment managers do you know that beat the S&P 500 by double digits?). The money market guys that were buying ABCP to "juice up" their returns over T-bills easily beat their benchmarks for years until one day that market seized up (who would have thought the safest asset class, cash, would get whacked by contagion effects from the U.S. credit crisis?). The fund of hedge fund manager who invested in illiquid hedge fund strategies easily beat his benchmark of a spread over T-bills until certain strategies blew up once the credit crisis developed. Let me be clear: there are serious issues in pension fund governance that need to be exposed. Pension funds should begin by disclosing the benchmarks for each and every investment activity underlying the overall returns and clearly identify who is responsible for each activity. They should stop bundling investment activities together and clearly report returns and benchmarks for internal and external managers. Only then will the key stakeholders understand whether or not the appropriate risks were taken to reach the returns, justifying the compensation being paid out.

It is up to the Board of Directors of each pension fund to ensure that each benchmark accurately reflects the investment risks of each investment activity, otherwise you risk vast discrepancies in compensation between your private market managers and public market managers. Pensions funds should be proactive and publicly post a document that clearly explains the benchmarks for each and every investment activity and whether or not they accurately reflect the risks of the underlying investment activity of both internal and external managers (for example, even though they are not perfect, see Ohio Public Employees Retirement System's investment policies).

Stakeholders do not have the expertise nor the time to scrutinize annual reports from large public pension funds. My aim here is to assist government supervisors, journalists, and the general public to demystify pension fund activities and to shed some light on issues that do not get the attention they warrant.

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This blog was created to share my unique insights on pensions and investments. The success of the blog is due to the high volume of readers and excellent insights shared by senior pension fund managers and other experts. Institutional and retail investors are kindly requested to support my efforts by donating or subscribing via PayPal below. To get latest updates, even during the day, click on the image of the big piggy bank at the top of the blog. For all inquiries, please contact me at LKolivakis@gmail.com.

About Me

I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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